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3. Commodity Options Trading Analysis

This commodity options trading analysis chapter describes how to analyze commodity options to identify those which have a high likelihood of being profitable.

A.   Analyzing The Markets

First, you must analyze the futures market to identify the current (and likely future) price trend. The complete Commodity FUTURES Trading Course^TM gives you the tools to help you intelligently analyze the futures markets and identify options which have a high probability for profit. This is what losers don't do. There will be times when your analysis suggests that a commodity is ready to start a major move. But the margin may be too large, or it may be volatile and the futures contract may require a large stop-loss risk amount ($1,200 to $2,500 or more) to avoid getting easily stopped out and is an amount which your money management rules prohibit. In other instances, the margin may just be too high. In these cases, you can use an option if your money management rules permit its purchase.

B.   Tracking Premiums

When you are considering the purchase of an option, you should first track the price of the option for at least two weeks. During this time, the premium of the option will likely change, giving you the opportunity to buy an option at a better (cheaper) price. An Option Tracking Form^TM is included with this trading course (See Appendix C) to help you monitor and track selected option premiums.

C.   What Strike Price Should I Choose?

Ideally, the option you select for trading should be within (but no more than) three strike prices out-of-the-money. This gives you an option that has a better chance of being profitable. As a general rule, an option with a strike price that is either at-the-money or is close to the price of the underlying futures contract is a good selection.

A call option is out-of-the-money if the strike price is above the price of the underlying futures contract. Likewise, a put option is out-of-the-money if the strike price is below the price of the underlying futures contract. In both cases, the further away the strike price is from the market price, the deeper out-of-the-money the option will be.

Although a deep out-of-the-money option is cheap, the payoff can be huge, but only if the underlying futures price moves beyond the option's strike price before the expiration date. However, in most cases this rarely happens and the option will expire worthless. The premium paid, although small, is lost.

A deep out-of-the-money option is generally a poor choice because the underlying futures price has to make a significant move for the option to become profitable. Amateur traders are lured into buying deep out-of-the-money options because they are cheap. I advise you to avoid deep out-of-the-money options unless there is some significant reason to warrant their purchase (such as an impending major price move suggested by the trading tools). Although these options are cheap, you must also consider the commission and fees as part of the cost, which can sometimes be a negating factor. If you do purchase a large quantity (5 or more) of cheap options, always ask for (and expect) a quantity discount from your broker.

D.   Practical Rules for Selecting Options

After you have analyzed the markets, you must first determine how much you want to risk. Your money management plan will be part of this determination. You should also consider the margin required for a futures contract as compared to the premium paid for the option. With commodity futures contracts, the margin is a refundable deposit – if you are correct about the direction of the move. With options, the premium is a non-refundable cost. For speculators, options work best in volatile markets because you don't get stopped out. They give you "staying power" – for a price.

Use the following items as a guide to help you in selecting a simple option position.

• The option type (will you be trading a call option or a put option)
• Buy an option with as close to 3 months before expiration as possible.
• Buy an option within 3 strike prices away from being in the money.
• Never risk more than $300 of the premium paid for the option.
• When possible, buy an even multiple of options (i.e., 2, 4, 6, 8 options, etc.)

Option Type
If you expect the futures price to increase, you will buy call options. If you expect futures price to decline, then you will buy put options. Call options tend to increase in value when the price of the underlying futures contract goes up. Likewise, put options increase in value when the price of the underlying futures price goes down.

What Option Expiration Date
Which option you choose is very important. Because options for each underlying futures contract delivery month have a limited amount of time, you want to buy enough time so that the expected move occurs before the option expires. You need to know how much time is available for the selected option before it expires. An option with about three months of time left until it expires is a good choice. Options with more time value before expiration are more expensive. Also remember that the option may expire upwards to a month before the underlying futures contract expires. In addition, exaggerated futures price swings often occur when options expire.

What Strike Price
You need to select a favorable strike price for the option you want to buy. The strike price determines the current cost of the option. For calls, the closer the strike price is to the futures price, the more expensive the option will be, but the greater the chance the option will make money – if your analysis is correct. If the futures price is higher than the call strike price, then the call option will be in-the-money. Although in-the-money calls are expensive, they also have a higher probability of being profitable. If the futures price is lower than the call strike price, the option is considered out-of-the-money, and will be incrementally less expensive for progressively higher strike prices.

Puts are in-the-money when the futures prices is lower than the strike price. Puts are out-of-the-money if the strike price is lower than the underlying futures price. Puts get cheaper as the strike price gets lower than the price of the underlying futures contract. For most markets, the value of an at-the-money put or call option with one month to expiration usually is in the $400 to $1,500 range.

Control Your Risk
You should never risk more than $300 of your money with an option, especially true with expensive options. When the option's premium gets to $300 less than what you paid for it – liquidate the option. This way, you put a "cap" on the loss you incur.

Getting Multiple Options
If your money management plan permits it, you should get at least two (or multiples of two) options when the trade appears to have two targets (i.e, daily 50% target and weekly 50% target). This lets you take profit on half the options when the daily target is hit and lets you profit even more if price continues moving to the weekly target.

Note: The rest of the information in this chapter is only available in the complete Commodity OPTIONS Trading Course^TM.

The next chapter covers Selecting Options For Profit.

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